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Finding your “real” Interest Rate – Inflation and Auto Loans

last updated January 22, 2014 by

When you take out an auto loan, the interest rate that you are quoted by the lender is actually not the only number that you should consider when you start to figure out your payments.  The financial impact of your car purchase is virtually guaranteed to be smaller than it initially appears, thanks to a little thing called inflation.  Inflation gradually reduces the value of currency in the long-run, and it means that the balance of your loan will be worth less as it continues to age.

How Does Inflation Affect Auto Loans?

The math behind inflation and loans isn’t very complex, but it still requires a basic understanding of the mechanics behind inflation itself.  Basically, every year there is more and more currency in circulation, so the total value of each dollar goes down over time.  There are many reasons why a healthy amount of inflation is necessary for the economy, but suffice it to say that it causes a rise in the average prices of goods and the average salary over time.

If you were to put $100 in a suitcase, and you were to dig it up twenty years from now, that money would not be worth as much.  What would purchase 100 cheeseburgers today might only purchase 20 cheeseburgers in the future.  This same principle applies to your loan balance as well.  A $10,000 loan balance that you maintain over the course of several years might still be $10,000, but that $10,000 will be worth less in the future because of the inexorable march of inflation.

Factoring Inflation Rates into Auto Loan Interest Rates

Because of the way that inflation will affect your loan balance, you can actually count the rate of inflation against your loan interest rate.  While interest on your loan gradually increases the balance of the loan, inflation theoretically decreases the value of the loan over time.  If your interest rate is 7%, and the expected rate of inflation is 2%, then your effective interest rate is only 5%.

Tips and Concerns with Interest Rates

One of the reasons that you might want to factor the rate of inflation into your loan calculations is because it changes the real value of your car loan over time.  A car loan actually isn’t a bad deal, and with interest rates at an all-time low you can usually find an auto loan with an interest rate that is very close to the inflation rate.  You might not actually want to pay a large down payment if the total interest rate of the loan is below the expected return that you would receive on investments or bonds.  For example, if the interest rate on your loan is 5% and the expected rate of return from the stock market is 8%, you would actually be best served by carrying a high loan balance and leaving the majority of your money in the investment account.